Why Private Equity Is Profitable

Mitt Romney recently attacked Newt Gingrich for working as a lobbyist in Washington. The public being naturally suspicious of politicians who make money off of public service, Gingrich must offer slippery explanations of his lobbying income. Rick Santorum has the same problem.

Romney seems to stand apart, having made his $250 million fortune in the private sector. But Americans sense that his fortune is unlike those of Henry Ford and Steve Jobs, visionaries who created something from nothing. Corporate raiders may deserve remuneration for reallocating resources to their best use — but hundreds of millions? It is the scale that grates, and correctly so, for it was not value creation but government policy that made the industry so lucrative.

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#ad#In the early 1960s, classical economics at the national policy level was replaced by the Keynesian consensus, which called for a program of constant inflation. One unintended consequence was the concentration of economic activity into large firms.

Firms grow in response to inflation for two reasons. First, inflation causes prices and interest rates to be unstable, making it difficult for private firms to plan. Companies amalgamate into conglomerates to allow management to make long-term operational and capital decisions that use internal resources and ignore the unstable prices. Second, modern governments print money by injecting new funds into the banking system. The banks in turn lend money to those clients that have a capacity to absorb extra financing in large increments — i.e., large firms.

As large firms grew in size, gaining tens of thousands of employees, they became difficult to manage. The consulting firm evolved to solve this problem. Teams of consultants investigate every level of a firm in order to give senior management the information required to dissolve internal fiefdoms and streamline operations.

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When successful, consultants increase the capital value of the client. But consultants soon realized that instead of working for paltry fees, they could buy companies outright, reorganize them, and then resell them, thereby capturing all of the capital gain for themselves. Thus, in 1983, Bain Capital emerged from Bain Consulting.

These new private-equity firms were long on management theory but short on capital. They needed to borrow huge amounts of money to buy their targets. In fact, the private-equity firms did not borrow the money themselves; rather, the assets of the acquired firms served as collateral for the loans needed to pay the former owners. The banks, engorged with extra money printed by the Federal Reserve, were pleased to provide the capital. As private-equity firms flourished, the debt burden on American companies rose dramatically.

Americans are now familiar with how the housing market became intertwined with debt. As the Federal Reserve pushed interest rates lower over the past 30 years, a given amount of income could command an increasingly large mortgage, and that increased housing prices. As housing prices rose, the homeowners with the least equity made the largest gains as measured in percentage terms — further encouraging higher, and more reckless, debt levels.

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#page#The private-equity industry functioned exactly the same way, levering multi-billion-dollar companies with tiny amounts of equity. The less equity invested, the more profitable the investment. The most lucrative deals were buying, levering, and dismantling large conglomerates that had been rendered anachronistic by the disinflation of the 1980s. Private-equity firms made fortunes reorienting firms from the inefficiency of conglomeration to the instability of excess debt.

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The housing crash has forced the Federal Reserve to reduce interest rates to zero in an attempt to keep the societal debt pyramid from collapsing. These low rates sustain not just housing, but the teetering private-equity firms and, by extension, the banks as well.

#ad#The main challenge the next president will face is how to respond to a crack in the American bond market, an event being previewed in Europe. When the market forces interest rates back to a more normal 5 percent, or to temporary-crisis rates above 10 percent, the housing market, private-equity companies, and banks will implode.

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Mitt Romney’s fortune, gained from consulting in the 1970s and private equity in the 1980s, is a byproduct of the Keynesian monetary policies followed by both Democrats and Republicans. That monetary policy is nowhere discussed in Romney’s 59-point economic plan suggests that he has no plan to meet the primary threat to American prosperity.

The one candidate who does understand the interaction between monetary policy, wealth, and liberty, Ron Paul, is unlikely to get the nomination. But his insurgent candidacy might finally force the Republican party to reject the Keynesian consensus. In fact, Gingrich mentioned Jim Grant, Lew Lehrman, and the gold standard in a recent debate. It is a good start.

— Daniel Oliver Jr. is the founder of Myrmikan Capital, LLC, and a director of the Committee for Monetary Research and Education. He has a J.D. from Columbia Law School and an M.B.A. from INSEAD.

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